Our Case for Value Investing

In the universe of stock selection styles, a distinction is made between investing for growth and
investing for value.

Growth investing is designed to find companies which are growing quickly, and which are
likely to continue doing so in the future. Because growth prospects are based on forecasts
which are usually public knowledge, the stock prices of hot growth companies are often very
expensive relative to their current earnings or assets. In general, growth investors don't care.
They will buy stocks which are expensive on the expectation that strong growth in the future
will vindicate the current price and more.

During the rise and fall of the dot com boom, the dangers of growth investing became obvious.
When expectations of strong growth did not pan out, the high prices of growth companies
were seen to rest on thin air, and a crash followed. The list of technology and internet companies
which once traded above $50 or even $100 per share, but which later fell to single digits or
failed completely, is huge. A partial list includes Copper Mountain Networks, Excite, Exodus
Communications, Iomega, and Pets.com. On the other hand, when growth companies do succeed,
they reward their investors well. Famous growth companies which rewarded investors
handsomely include Microsoft, Dell, Intel and Oracle.

Value investors, by contrast, are a more cautious bunch. They look for stocks which are underappreciated
by investors and which trade at a low price relative to current earnings or assets.
In essence, the companies are on sale. Often, value stocks have been overlooked not because
the company is in trouble, but because it engages in businesses which are boring and do not
grab headlines. Outstanding value stocks of the last several decades include Golden West (a
savings bank), Leucadia National (a conglomerate) and Diageo (a liquor company). Successful
value investors who built large fortunes include Benjamin Graham and, most famously, Warren
Buffett.

On this issue, we at D. Mattersdorff believe in value investing. We do so for several reasons:

The long term risks and returns of value investing in comparison with growth investing
greatly favor value. Research by Eugene Fama and Kenneth French, two pioneers in portfolio
science, supports this point. Over 80 years, $1 invested in a portfolio of growth stocks
has grown to $1,893, while $1 invested in a portfolio of value stocks has grown to $47,661
(see chart in sidebar).

The value portfolio has grown with less risk. This makes intuitive sense. Companies
which have been overlooked by investors do not have huge growth premiums already
built in to their stock prices. If things go wrong, such stocks tend to fall less. It's not that
value stocks can't fail - of course they can and sometimes they do. However, a margin of
safety exists which does not exist in the price of sky high growth stocks. The less volatile
red line in the chart above shows this margin of safety at work.

An additional advantage of value stocks is that sometimes, they also surprise with higher
than expected growth. Indeed, strong growth from these companies comes as a surprise
by definition, because the expectations of investors were previously set so low. Leucadia
has been priced as a value stock since the 1970s. In that time, book value per share has
grown from 11¢ to $19.68, a compound annual growth rate of 18%. The stock price has
gone from 12¢ to $32 over the same time period.

In summary, our bias for value is driven by our desire to provide the highest returns for our
clients with the lowest possible risk. Value investing does not make headlines or excite the
passions of investors. Brokerage firms do not emphasize it. It never appears on CNBC because
it is so boring. All of these are points in its favor. Value investing works precisely because
it is neglected by such a large portion of the investing public. Investors who embrace
value investing greatly enhance their long term prospects for success, and we as advisors embrace
it for the same reason.